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Equities: please don’t supersize me!

In the second half of 2009 many market commentators, including ourselves, thought that 2010 would become a great year for Mergers & Acquisitions. After all, balance sheets were strong, borrowing costs were low and there were plenty of target companies which generated attractive free cash flow yields. However, the reality proved us wrong, at least with regard to the first half of 2010. Global M&A did only rise by 8% in dollar terms versus the very poor first half of 2009 (source: Mergermarket), much less than expected. Why do executives of big, cash rich companies not go on a buying spree? And what are the consequences for investors?

The most probable reason for the lack of growth in M&A volumes is the simple fact that uncertainty about the future of western economic growth is still high, arguably higher than in previous recovery periods. A cool observer could of course state that this uncertainty is also reflected in the attractive valuation of potential targets, but many companies rather want to pay a higher price in a stable market than a lower one in an environment with less visibility.

Another reason for the disappointing trend in M&A may be found in the explosive growth of emerging markets. Many western companies want to expand their exposure to areas of growth and the best way to do so now is by increasing exposure to emerging markets. However, doing so through M&A is often difficult, given the lack of suitable candidates (in terms of valuation and culture) in those countries. Most western companies therefore are increasing their presence in these countries through organic growth or very small acquisitions.

If we switch our attention from companies to the equity markets we see another reason why executives may have a disincentive for increasing the size of their companies. Over the past ten years, there has been a strong correlation between company size and equity performance; the bigger the company, the worse the stock price development! This has not always been the case. In the nineties the larger companies generally were the star performers, driven by huge inflows into equity markets (“big stocks” need a lot of fuel) and the need for single-country investors to follow the trend toward European unification through buying broad European portfolios. The latter was often done by buying the (Euro)Stoxx 50 index, which consists of the largest and most liquid companies.

This pattern changed significantly in the past decennium. The inflows into equities dried up and the unification repositioning was behind us. In the bear markets, investors sold the most liquid names. The large stocks suffered. Besides this, the growing hedge fund community usually preferred to invest in smaller stocks, which better fitted their investment strategies than the relatively immobile giants. As a result, smaller capitalised stocks outperformed the larger ones in almost each of the past ten years.

However, investors know: trends come and go. The decennium in which it was unwise to buy “supersized” companies is probably behind us. After all, we are now facing a situation in which the large, stable companies with strong balance sheets are significantly cheaper and pay higher dividends than their smaller, more risky counterparts. Historically, the difference in valuation has rarely been bigger. Small may be beautiful, but it has become relatively expensive. It may be wise to go for the unloved giants again.